South Africa Could Use a Rest

01/24/2011 9:55 am EST

Focus: GLOBAL

Prieur du Plessis

Author, Investment Postcards from Cape Town

The powerful rally in Johannesburg stocks looks overextended, writes Prieur du Plessis of Investment Postcards from Cape Town.

South Africa's perfect investment storm of slowing inflation, a stronger rand, higher inflation rates than in developed markets, an extremely successful soccer World Cup and, on top of it all, an invitation to join the BRIC countries, continues to lure foreign investors. In 2010, Johannesburg's FTSE/JSE All Share Index returned 33% in US dollars-double the 16.4% rerun for the MSCI Emerging Markets Index and nearly 3.5 times the MSCI World Index's 9.6%.

Over the past quarter the South African equity market returned a staggering 15.1% in US dollars, income and dividends reinvested, significantly outpacing the MSCI World Index's 8.6% and MSCI Emerging Markets' 7.1%.

The million-dollar question is: What about valuation? I prefer to use Robert Shiller's Cyclically Adjusted Price/Earnings Ratio, or CAPE in short. CAPE is calculated by dividing the real stock index by the average real earnings over the past ten years, thereby smoothing the earnings fluctuations from year to year.

The historical CAPE of the FTSE/JSE All Share Index over the past 18 years was 17. The CAPE is currently 19.6, or 15% above the historical average, rendering the South African stock market somewhat expensive.

The problem is that no one knows when the market will revert to its historical average. If you base your investment decisions solely on CAPE you may be out of the market for a very long time, as happened from 2005 to 2008, and miss significant upside.

The current P/E ratio of the FTSE/JSE All Share Index of 17.2 is 30% higher than the historical average of 13.2 since 1982 and 15% higher than the average since 2004.

South African equity prices are discounting the earnings base to grow by 18% to 24% over the next 12 months. The anticipation may be on the high side, especially with consumer spending under continued pressure, but it is not unachievable.

While there is still some upside in South African stocks, the market is extended. It is perhaps time to bank a few profits.

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